Tools of the Trade: Two Experts Talk About Family Business Succession
Q. How important are buy-sell agreements and clearly established valuation methods for family shareholders? What are typical valuation methods?
A. A buy sell agreement is a succession planning tool that; (i) protects existing shareholders against transfers of ownership to nonfamily members or parties they do not want as “partners;” (ii) provides for a well thought out method of transferring management and ownership of the business to the next generation; (iii) addresses when and how an existing owner may be able to sell their ownership interest; (iv) provides a means of valuing the business in the event of an ownership transfer; and (v) determines how payments will be made to a transferring owner in order to protect the ongoing viability of the business.
Common valuation methods are; (i) annual determination of value by the owners; (ii) a formula approach; or (iii) determination of fair market value by independent appraisal. Additional information on business valuations can be found at www.MandAlawyer.com by clicking on the tab on the left side of the home page titled “Business Valuations.”
Q. What are your recommendations for pre/post nuptial agreements for family members working in the business who do not have ownership but may be having ownership in the future?
A. Many families use pre and/or post nuptial agreements to protect assets that were acquired before marriage and to keep shares within the family. The effectiveness of such agreements is dependent upon state laws so discuss this with an attorney before making such a requirement. If you do want to require agreements of this type before someone is allowed to become an owner make it should be discussed and planned well in advance of engagements.
Q. Do you advise to sell to a family at a discount price?
A. Generally, minority owners are the ones that face a possible discount on the sale of their stock. Whether or not there is a discount applied may depend on whether the event triggering the sale is voluntary or mandatory. If the minority owner just “wants” to get out versus a buyout due to death or disability, it is more likely that there would be a discount. Discounts tend to give majority owners an unfair valuation advantage and are generally avoided in buy sell agreements.
Q. What range of discounts do you typically see for minority interest and lack of control?
A. Discounts are generally due to lack of marketability and lack of control. These discounts also overlap. Lack of marketability discounts range from 20% to 45% for privately held ownership interests and minority ownership discounts also range from 20% to 45%. Different appraisers apply these discounts in different ways and in different combinations, but rarely would the total discount exceed 40%.
Q. Where are good places to find advisers to help with providing ideas for liquidity for the outgoing generations? We have found that local banks don’t provide the level of experience or expertise required.
A. For information on selecting advisors see www.MandAlawyer.com and click on “M and A Professionals” on the left side of the home page. The right professional “team” is the key with the right leadership.
Q. What’s your experience with what family members are involved? Spouses and partners are the people I struggle with – how involved should they be?
A. It is important to clearly define family for the purposes of ownership. If spouses are allowed to own some provision may need to be made for the business to purchase their shares in the event of a divorce. Life-partners are treated much the same as spouses in most states and therefore, would need to be considered the same as spouses. There is no simple answer but there needs to be open discussion within the family and good documentation of decisions for future reference. Since spouses and in some cases life-partners are influential in raising children who will be the next generation their cooperation and participation in the family business continuity plan is often critical.
Q. Can you review the valuation process you described with the two owners and two envelopes bids?
A. The simplest form of the “shoot out” is when two partners (A and B) provide bids for the company in sealed envelopes. The envelopes are opened at a meeting of the parties and the highest bidder has the right to buy out the other owner. If the A is the highest bidder and does not buy out B’s interest, then the B, the lower bidder, has the right to purchase A’s ownership interest at the price bid by B. In a multiparty shoot out the rights would go from the highest bidder, in order, down to the lowest bidder.
Q. How is stock valuation different than an appraisal?
A. They are the same. Stock values should be set based upon an appraised value. Share prices increase when valuations increase.
Q. What are the unique concerns for succession of a C corp? My retirement fund is currently 90% company stock.
A. The fact that a “C” corporation is not a pass through tax entity (C corporations are taxed at the corporate level and the shareholders are also taxed on dividends from the C corporation) requires additional tax planning to make sure the buy sell agreement, current ownership structure and future business operations are all structured in a manner that minimizes the double tax.
Q. Is there any published stuff out there on typical valuation methods for private companies for those with minority interest?
A. Google “discounts on minority interests” and you will find volumes of material. One of the leading writers on this issue is Lance Hall with FMV Opinions. Applicable information can be referenced through FMV’s web site at www.fmv.com.
Q. What are the steps to help a family transition to a family business office if they have not considered it before?
A. Generally, a family office is useful when a family reaches a size and net worth that can support central functions such as investment planning, tax planning, philanthropy and even clerical services. If the separate needs of the family are placing an inappropriate burden upon the staff of the business it might be wise to consider a family office.